A. Undervaluation does two things. It shifts your employment and production toward export and import-competing tradeables-producing industries. It also gives you lousy terms of trade. Dani wants to argue that the first is good--that there are powerful wedges which make emerging-markets countries, especially, prone to have too small a share of employment and production in those export and import-competing tradeables-producing industries. But the second has to be bad for growth.

I realize that this is the room in which Charlie Schultze back in 1984 carried out his intellectual police action against the industrial-policy tradeables-subsidizing faction of Gary Hart, Bob Reich and company. And it seems that you don't you want to push your argument further and say that--at least with a relatively-autonomous, technocratic state apparatus, at least for emerging-markets economies--that Gary, Ira, Bob, and company were right. Why not? You identify market failures, and then you say that direct subsidies to neutralize them run into problems of implementation--but I want to see you spend more time on the implicit theory of government failure that underlies your conclusion that depressing the value of your currency is the best strategic intervention that a government can undertake. There must be a strongly-held view of government failure underlying this conclusion. What is it?

B. Let me ask two questions. First, a general question: the Balassa-Samuelson fact tells us that economy-wide productivity growth is predominantly growth in the efficiency of making tradeables. What's wrong with taking what Paul Romer has been telling us for thirty years seriously, and saying that this is simply a corollary to the Paul Romer view of the world? Of course learning-by-doing and other effects matter, and of course they matter more in those industries which are the centers of technological progress--which are the tradeables?

Second, a specific question for Dani, who continues here to pursue his long-run plan of making space for social democracy in a neoliberal age. Dani: You are cautious. You don't want to push it far enough to say that--at least with a relatively-autonomous, technocratic state apparatus, at least for emerging-markets economies--the industrial-policy arguments against which Charles Schultze carried out an intellectual police action in 1984 in this room are correct. You identify market failures, and then you say that direct subsidies to neutralize them run into problems of implementation, and conclude that depressing the value of your currency is the best strategic intervention that a government can undertake. There must be a strongly-held theory of modes of government failure underlying your conclusion. What is it?

C. How do you keep undervaluation going for long? It produces, as we saw in Europe at the end of the 1960s and as we see in China now, rather a lot of inflation. What are the long-run costs of that inflation? Is there a link between the success of European development in the 1950s and 1960s and the long period of prolonged high unemployment in the 1970s and 1980s?

A. I feel stupid, like I do not understand what is going on, at all, on a very basic level.

$2T of total losses--$650B of credit losses--should not risk bringing down a global economy with something like $100T of total capital. Diversification. Long term assets are risky. They rise and fall in price. With an average global duration of income from capital of ten years, a 20 basis point global increase in real long-term interest rates has as large an impact on global wealth. And you can get that in a bad month. And we do. So why are we here?

One story I have heard is not that the market believed that the AAA-rated tranches were truly AAA, but that it did not so believe. The market demanded a premium of 15 basis points or so to hold these tranches, and so the originators turned to those who ran their organization's portfolios and said "please take these at par: they're AAA." And so the highly-leveraged Citi, UBS, BS, LB, others--the WWF--turn out to have a share of this $2T large relative to their capital, and have it because their portfolio managers never asked the American question: "If this is such a good deal for me to buy at this price, why can't you sell to anybody else?"

Is this really the underlying story? I have a hard time believing that this is really the story. But what is the other story? Is it really that catastrophic a failure of risk management? Is that what kept our modern global-spanning financial markets from properly mobilizing the risk-bearing capacity of the global economy to bear and spread the risk of a large housing downturn?

B. The past seventy years have seen the rise of government economic management of the "commanding heights" of the economy and then the fall in every sector except one: monetary policy. Perhaps the key price in the economy--the short-run terms-of-trade between the present and the future, the interest rate--is always and everywhere an administered price, administered by a group of monetary technocrats who seek as much insulation as possible from electoral politics. And over time the strength of non-market control over short-term interest rates, the solidity of this island of central planning in the center of our economies, has grown stronger and stronger. We do this because it seems to work in practice, even if it doesn't work in theory, or at least to work less badly than alternatives.

Now the Federal Reserve and the Treasury appear to be reaching for additional powers. The payment of interest on reserve deposits designed to decouple the short-term interest rate from other aspects of yield and risk curves. The extension of government guarantees to shift an extraordinary quantity of assets from "risky" to "safe" in an attempt to act on market risk premia directly--risk premia that economists have never been able to understand from first principles as reflecting any rational utilitarian tradeoff at all. And once again we are doing this because it seems to be needed in practice, or at least to work less badly in practice than the alternatives that are staring us in the face.

This is, I think, absolutely fascinating. Why is what one might call the socialism in one sector reaching higher and higher high-tide marks with each passing generation? Why has this Treasury here just participated in the greatest nationalization in history?

C. In a normal foreclosure, something bad has happened to the income or the circumstances of the particular homeowning household, so you foreclose, you pay the transactions costs, and then you find another wannabe homeowner household that can afford to pay more, and you profit--or at least limit your loss.

In today's market, something bad has not happened to the income or circumstances of the particular homeowning household. Every household facing foreclosure imagined that prices would rise for another year or two, that they would build up some serious equity, and could then refinance their high interest rate high loan-to-value loan with a normal lower interest rate normal loan-to-value loan. They were wrong. The people who built the house were wrong. But foreclosure does not help. You foreclose on that particular homeowning household, you look around for another household that can afford to pay more--and you do not find one. If there were another wannabe household that could afford to pay more, they would have bought already. So you foreclose, you pay the transactions costs, and then... you find that the household that can pay more does not exist, that the household you just foreclosed on is the one that can afford to pay the most.

And it is this situation that I have to ask: where is the Coase Fairy? Legal process is expensive. Empty houses deteriorate. West Nile virus breeds in the untreated swimming pools of the new developments in San Jose, and the virus-carrying mosquitoes move north into Palo Alto breeding in the pools left by lawn sprinklers. It is in situations like this where there are enormous gains from recontracting in which the Coase Fairy is supposed to come down from the sky and use his wand to make everything OK.

To defend Ricardo, Emmanuel, and my hallmate Pierre-Olivier, I at least think their model does have reserve accumulation by central banks: that is what pushes the safe real interest rate into the dynamically inefficient range. And I at least think their model does have substantial value--my favorite macroeconomics teacher was Olivier Blanchard, because he taught that any problem in macroeconomics could be modeled as a two-dimensional system of differential equations with a perfect-foresight saddle path that was shocked by completely unanticipated instantaneous jumps in parameters. And this mode of thinking has allowed me to at least convince myself that I understand a large amount of the world over the past three decades.

But I wish it had more value. I want more than a nice two-dimensional perfect-foresight system of differential equations here. I want a five- or a six-dimensional explicitly stochastic system. The paper is a model of inventory speculation and rational popping bubbles in the context of a global savings glut--of an equilibrium price for safe financial assets that gets too high to preserve dynamic efficiency. But we not only have a configuration of very high safe asset prices, we have--or at least the Treasury and the Fed are acting as if they believe we have--risky asset prices that are too low.

That is why the Fed and the Treasury have turned perhaps $100B of risky assets into safe assets via a number of acronyms I have not memorized, turned $30B of BS-held risky assets into safe assets, promised to guarantee the unsecured debt of every large investment bank in America, turned the $XT of slightly-risky GSE debt into safe debt, and are today getting ready to do something about Lehman (LEH).

General Comments:

In the interest of maintaining an optimally diversified intellectual portfolio in this room, I think someone should defend those who fairly recently bought houses in California, in Florida, and in Massachusetts.

Look, the flat home price-rental ratio we saw back before 2000 was not a fact of nature. Someday there will be a permanent fall in long-term world real interest rates. When we have such a fall--and I think we have had it already--the long-run equilibrium price-rental ratio is going to rise. Moreover, at some point the U.S. will fill up: falling federal transportation expenditures, rising population, rising household wealth, rising gasoline prices, and congestion will mean that there is no longer greenfield land at the Ricardian limit available within trivial commuting cost of where you want to be. When that happens, land in the U.S. will change from being essentially free to being a Hotelling good with a real price rising at the real rate of interest.

Both those changes--falls in long-term world real interest rates, and the filling-up of America--will raise the price-rental ratio. I assert on the back of an envelope that those account for half of the rise from flatline to peak of the price-rental ratio